carcello and reid - 2014 - investor reaction to the prospect of mandatory audit firm rotation

Overall, we find evidence of a significant and negative market reaction to six prominent events affecting the likelihood that a mandatory audit firm rotation policy is adopted in the U.S

Investor Reaction to the Prospect of Mandatory Audit Firm Rotation

Joseph V Carcello University of Tennessee Lauren C Reid University of Tennessee January 2014

Acknowledgements: We appreciate the helpful feedback we received from the 2013

AAA Auditing Midyear Conference participants as well as workshop participants at Florida International University and at the University of Tennessee’s Corporate Governance Center

Data Availability: Data are available from public sources identified in the text.

Investor Reaction to the Prospect of Mandatory Audit Firm Rotation

SUMMARY: The PCAOB is currently considering the implementation of mandatory audit firm

rotation in hopes of better aligning auditors’ interests with investors’ interests The PCAOB also recently proposed a standard that would require disclosure of auditor tenure in the audit report These actions seem to indicate that the PCAOB views long auditor tenure as problematic However, the accounting profession argues that long tenure actually improves audit quality This study provides insight into investors’ views by evaluating the market’s reaction to multiple events related to the potential adoption of rotation The results reveal that the market reacts negatively to the prospect of forced rotation In particular, the market reacts more negatively if the current auditor is an industry specialist or a Big 4 firm The reaction is also more negative if the company has high audit quality proxied via abnormal accruals Moreover, the market’s reaction is more negative given longer auditor tenure

Keywords: mandatory audit firm rotation; market reaction; PCAOB; investor perception

I INTRODUCTION

“[I]n recent years, we have seen an equally significant spike in deficiencies Year

in, year out, inspectors find deference to management in key reporting areas For

example, in the critical area of fair value reporting of financial instruments,

instead of skeptically testing the reasonableness of managements’ assumptions

and resulting assertions, one firm’s method involved obtaining valuations from a

number of external parties and picking the one that is, ‘closest to the pin’ – the pin

being management’s claimed value … the explicit acknowledgement that the test

was designed to support management’s number – the ‘pin’ – calls into question

whether the auditor approached the audit with appropriate skepticism.” (PCAOB

Chairman James Doty 2012)

As a result of the Public Company Accounting Oversight Board’s (PCAOB or Board) concern about auditors’ lack of professional skepticism, the Board has reopened a debate that began over thirty years ago and is considering whether indefinite tenure aligns the auditors’ interests with management rather than guarding investors’ interests One commonly recommended solution to this issue is mandatory audit firm rotation.1 In addition, given that the U.S House of Representatives has expressed its opposition to mandatory firm rotation (Tysiac 2013), the PCAOB may be implicitly encouraging firm rotation by proposing that audit firm tenure be disclosed in a revised version of the standard audit report (PCAOB 2013) Disclosure

of long audit firm tenure is likely to attract adverse publicity and unwanted attention and perhaps indirectly spur audit firm rotation, accomplishing what the PCAOB may not achieve through direct rulemaking Regardless of the PCAOB’s rulemaking efforts related to audit firm tenure and auditor reporting, mandatory firm rotation has been the focus of regulatory scrutiny for many years2 and will likely to continue to be of interest to regulators (DeFond and Zhang 2013)

1

Other audit regulators are examining the issue of mandatory firm rotation as well The U.K.’s Competition Commission decided against requiring mandatory audit firm rotation, but will instead require the U.K.’s largest companies to retender their audit engagement at least once every 10 years (U.K Competition Commission 2013) In addition, the European Parliament’s Legal Affairs Committee recently voted to require audit firm rotation once every 14 years (Singh 2013)

2

The current discussion is not the first time mandatory firm rotation has been a regulatory debate in the United

Proponents argue that mandatory audit firm rotation results in management being less able to influence auditors’ decisions and auditors being less inclined to issue reports that favor management (Ruiz-Barbadillo et al 2009) Another common argument for mandatory audit firm rotation is that a new auditor provides a “fresh look” at the company and its financial reporting (Lu and Sivaramakrishnan 2009) This different perspective can also improve audit quality and enhance independence On the other hand, some argue that the loss of in-depth knowledge of the client and its industry reduces the effectiveness of the audit (Lu and Sivaramakrishnan 2009) Opponents of forced rotation also believe that audit firm rotation is unnecessary as appropriate safeguards are already in place, including audit partner rotation, audit committee independence, peer reviews, the normal turnover of engagement teams, threat of audit firm reputation loss, and risk of audit firm litigation (GAO 2003; Ruiz-Barbadillo et al 2009) Opponents also cite academic literature on auditor tenure that generally finds that long audit tenure improves audit quality (DeFond and Zhang 2013), albeit in a regime where audit firm turnover is voluntary not mandatory Some of this research notes that audit quality suffers during the early years of the client relationship and leads to more instances of fraudulent financial reporting (Geiger and Raghunandan 2002; Carcello and Nagy 2004)

Mandatory audit firm rotation has received increased attention within the United States in recent years as the PCAOB initiated a discussion regarding the possible adoption of rotation and commenced the process of examining its merits and drawbacks While it is impossible to gather U.S archival evidence on the effects of a potential policy, it is feasible to study whether or not investors might value the policy (Zhang 2007; Li et al 2008; Armstrong et al 2010; Joos and Leung 2013) Generally following the approach used in Armstrong et al (2010) and Joos and

period of years” (U.S Congress 1976) In 1978, the AICPA issued the Cohen Commission Report, which dismissed

Leung (2013), we examine the U.S stock market reaction to several events that affect the likelihood that the PCAOB will adopt a mandatory audit firm rotation policy This research design allows us to measure the expected net benefits to the group, investors, that the policy is designed to benefit (DeFond and Zhang 2013)

Furthermore, the PCAOB received well over 600 comment letters in response to its Concept Release on audit firm rotation (Franzel 2012), but less than ten percent were from investors and their responses were mixed Therefore, it remains an empirical question as to whether investors support or oppose mandatory audit firm rotation In addition to testing for an overall stock market reaction, we primarily investigate if the market reaction differs based on firm and auditor characteristics The results of this analysis may be particularly informative to the Board as they reveal the possible triggers of investors’ reactions to the prospect of mandatory audit firm rotation

Overall, we find evidence of a significant and negative market reaction to six prominent events affecting the likelihood that a mandatory audit firm rotation policy is adopted in the U.S., suggesting that investors, on average, oppose forced rotation Specifically, the mean cumulative abnormal return across the rotation event dates is -0.0169, where the cumulative abnormal market return is calculated using an index of foreign stock returns since these firms would have been less effected by the PCAOB’s discussion of mandatory firm rotation We do not have a U.S.-specific control group because the PCAOB’s discussion of audit firm rotation included all SEC registrants Therefore, given the lack of a U.S.-specific control group, we focus primarily

on our cross-sectional tests.3 We examine whether there is a differential market reaction based on

audit firm industry specialization, audit firm tenure, Big 4/non-Big 4 dichotomy, and audit

3

We relax this assumption in the robustness section where we create a U.S.-specific quasi control group using

non-quality as proxied by abnormal accruals Based on these cross-sectional tests of auditor characteristics, we find that firms with an industry expert as an auditor experience a significantly more negative market reaction than firms without an expert auditor We also find evidence that the market reaction is significantly more negative for firms with long auditor tenure compared to firms with shorter auditor tenure Furthermore, companies audited by Big 4 accounting firms react more negatively to the discussion of mandatory rotation compared to companies audited by non-Big 4 firms In addition, our results suggest that companies receiving a high quality audit from their current auditors experienced a significantly more negative market reaction compared

to companies receiving a lower quality audit Our results are generally consistent with those in a contemporaneous work by Gerakos and Syverson (2013) who find, using a fundamentally different methodology, that a policy of mandatory firm rotation would result in consumer surplus losses of approximately $2.4 – 3.6 billion given the existing level of audit fees

Furthermore, we utilize non-event day returns as an alternative benchmark to test the significance of our overall market and regression results Using a similar procedure to Armstrong

et al (2010) and Joos and Leung (2013), we calculate cumulative market-adjusted returns for three consecutive trading days that are not captured in our event windows We then compare the mean market-adjusted returns across our event windows to the mean non-event returns to test the significance of the overall market reaction In our cross-sectional tests, we estimate additional regressions replacing the market-adjusted returns of our event windows with the non-event day market-adjusted returns as the dependent variable We compare the coefficients from the non-event regressions to the coefficients obtained in our main model to test the significance of our variables of interest This procedure ensures that our results are not a product of systematic relationships between our test variables and cumulative abnormal returns in any three-day

window, but rather are specific to the event windows and therefore the prospect of mandatory audit firm rotation

This study contributes to the debate on firm rotation by providing the PCAOB and other regulators with relevant and timely information regarding the market reaction to the prospect of mandatory rotation As regulators are considering the implementation of this regime in order to protect investors, it is interesting to note the negative market reaction to the possibility of mandatory auditor rotation It appears that investors respond negatively to the discussion of mandatory rotation as they value the expertise of their current auditor and perhaps believe that any potential benefits of rotation, such as improved independence, would likely be outweighed

by its costs It also appears that investors view rotation as especially undesirable for companies utilizing an industry expert or Big 4 auditor, and companies that have a longer relationship with their audit firm In addition, this study indicates that investors are more opposed to forced rotation if firms are receiving high quality audits from their current auditor These results suggest that investors have reservations about the possible implementation of rotation for certain firms and that a one-size-fits-all approach might not be appropriate should audit regulators continue to explore the prospect of mandatory audit firm rotation

The remainder of the paper is organized as follows Section II provides further background on mandatory audit firm rotation and develops our hypotheses Section III describes our research method, and Section IV presents our results and robustness tests The last section discusses limitations and concludes

II BACKGROUND AND HYPOTHESES PCAOB Consideration of Mandatory Firm Rotation and Event Dates of Interest

The possibility of mandatory firm rotation was discussed when Congress was drafting the Sarbanes-Oxley Act (SOX) of 2002 However, Congress determined that more research was

needed to see if audit partner rotation, among numerous other measures, was sufficient in

addressing independence concerns Therefore, Section 207 of SOX commissioned the General Accounting Office (GAO) to study mandatory firm tenure limits.4 In 2003, the GAO issued a report stating that the SEC and PCAOB would need several more years to determine whether or not the SOX reforms provided enough protection for investors against entrenched audit firms The GAO concluded that audit firm rotation ‘‘may not be the most efficient way to strengthen auditor independence and improve audit quality’’ (GAO 2003).5

Over the past eight years, the PCAOB has conducted almost two thousand audit firm inspections (Hanson 2012) and has found several hundred audit failures (Doty 2011) The continuing inspection problems found by the PCAOB have prompted the Board to revisit whether audit firm rotation would improve audit quality As stated previously, PCAOB Chairman Doty has expressed concern that long auditor-client relationships can create an incentive to please the client This perverse motivation clouds the auditors’ judgment and can cause a lack of professional skepticism as well as a failure to obtain sufficient audit evidence On June 2, 2011, Doty publicly stated his belief that steps need

to be taken to shift the auditors’ “mindset to protecting the investing public” In his speech, he notably remarked that “it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against [it]” (Doty 2011) Doty also announced the PCAOB’s plans to issue a concept release in the near

future to formally explore rotation As the Chairman’s speech was the first significant statement regarding the PCAOB’s consideration of mandatory rotation since the drafting of the Sarbanes-Oxley Act of 2002, we classify June 2, 2011 as our first event date that increases the likelihood

of adoption

On August 16, 2011, the PCAOB issued a Concept Release to solicit public comment on ways to enhance auditor independence, skepticism, and objectivity, including the possible introduction of a mandatory audit firm rotation policy (PCAOB 2011b) The Concept Release presented numerous questions regarding the benefits and costs of mandatory audit firm rotation and also requested input as to how such a policy would be implemented We classify the issuance of the Concept Release as our second event that increases the likelihood of mandatory rotation

The third event occurred on September 23, 2011 when PCAOB Member Jay Hanson spoke at the SEC Financial Reporting Conference Since the issuance of the Concept Release, it was the first time a board member made public comments regarding mandatory audit firm rotation Hanson stated his belief that “the Board should proceed cautiously along the path toward mandatory auditor rotation.” He explained several of his concerns, including increased financial costs, decreased audit quality in the first years of a new engagement, and the possibility that “auditor independence could suffer in a mandatory rotation framework, because audit firms may step up their marketing of non-audit services to audit clients near the end of the permissible term of the audit engagement” (Hanson 2011) As this event represents a Board Member’s hesitation regarding mandatory firm rotation, we view this event as a decreasing the likelihood of policy implementation

On October 4, 2011, Board Member Daniel Goelzer also publicly voiced his concerns regarding forced rotation He expressed that he has “serious doubts that across-the-board mandatory rotation is a practical or cost-effective way of strengthening independence” (Goelzer 2011) Goelzer mentioned only requiring rotation in special cases such as when a PCAOB inspection report cites a professional skepticism issue (Goelzer 2011) We view this fourth event

as also decreasing the likelihood of rotation, especially because two of the five Board members had essentially indicated their opposition to rotation by this point

The last two events included in our study involve a Congressional proposal to prohibit the PCAOB from mandating audit firm rotation On March 23, 2012, the House of Representatives announced a hearing to be held on March 28th by the Committee on Financial Services to discuss

an amendment to SOX that Representative Michael Fitzpatrick of Pennsylvania proposed (Whitehouse 2012; U.S House 2012) This amendment would preclude the PCAOB from implementing any regulation that requires auditors to be rotated We classify the March 23rdannouncement and the March 28th hearing as events that decrease the likelihood of rotation.6

Evidence in Favor of Mandatory Audit Firm Rotation

Proponents of mandatory audit firm rotation argue that long tenure impairs the independence of the auditor This argument is grounded in the theory developed by DeAngelo (1981), which states that a client provides the audit firm with an annuity of quasi-rents that it expects to receive throughout its relationship with the client This incentivizes the auditor to make sacrifices in order to maintain the client relationship and guarantee its annuity, which can diminish auditor independence (DeAngelo 1981)

6

The U.S House of Representatives approved a bill that would preclude the PCAOB from implementing mandatory firm rotation on July 8, 2013 (Tysiac 2013) We do not separately analyze this date because by early July 2013 it was obvious to informed observers that the House of Representatives was opposed to firm rotation, and given that

Behavioral studies have investigated the potential benefits and costs of imposing mandatory audit firm rotation, and these studies generally are supportive of audit firm rotation Dopuch et al (2001) experimentally test the effect of regulating firm rotation on auditor independence and find that such a policy decreases the auditor’s propensity to issue reports that please management and thus increases independence In a similar vein, Wang and Tuttle (2009) perform an experiment to test the impact of rotation on the negotiation process between clients and auditors The authors discover that in the absence of mandatory firm rotation, auditors are more concerned with appeasing management and tend to use “obliging” strategies in negotiation whereas with a mandatory rotation regime, auditors are not motivated by their need to maintain the client relationship and are therefore less inclined to cooperate with management (Wang and Tuttle 2009)

Using an archival approach, Nagy (2005) collects data within the United States where a forced auditor change occurred, although not as a result of mandatory firm rotation He uses the demise of Arthur Andersen to examine the effects of a mandatory auditor change on audit quality Using the absolute value of discretionary accruals as a proxy for audit quality, he finds that a forced change in auditors increases audit quality for relatively small companies (Nagy 2005) Examining a similar setting, Kealey et al (2007) find that new auditors charge former Andersen clients higher fees given longer prior tenure, suggesting that auditors view a longer prior tenure with Andersen as an indication of heightened audit risk In addition, some local governments require mandatory firm rotation For example, some jurisdictions in Florida require audit firm rotation whereas others do not Lowensohn et al (2007) find that financial reporting quality is higher in those Florida jurisdictions that require rotation as compared to those jurisdictions that do not

While research surrounding mandatory firm rotation in the United States is limited, foreign settings where rotation is currently in place or once was implemented provide the ability

to more directly study rotation’s effects Chung (2004) examines companies in Korea before and after the passage of its mandatory rotation rule The author reports lower discretionary accruals subsequent to the implementation of the requirement, which suggests that audit quality improved due to the enhanced incentives to maintain auditor-client independence (Chung 2004) Kwon et

al (2010) also study Korea’s mandatory audit firm rotation regime; however, Kwon et al find different results They find that audit hours and fees increased, but that audit quality (measured using abnormal discretionary accruals) remained unchanged or slightly decreased

In addition, prior studies on auditor tenure and audit quality might provide some information on the benefits and drawbacks of audit firm rotation However, it is important to carefully extrapolate from studies using regimes where auditor turnover is voluntary to regimes where auditor turnover would be mandatory (Casterella and Johnston 2013) Notwithstanding this caveat, there are a number of studies that examine auditor tenure and various financial reporting and market outcomes Davis et al (2009) analyze the relation between auditor tenure and earnings management in pre- and post-SOX eras Davis et al find that prior to the passage of SOX, auditor-client relationships lasting fifteen years or more are associated with higher levels

of accruals earnings management (Davis et al 2009) However, post-SOX, they find no significant relation between tenure and earnings management This change in the relation between auditor tenure and earnings management might be due to auditor performance being more closely scrutinized post-SOX, and also due to an increased risk of regulatory action against auditors (Davis et al 2009) Additionally, Dao et al (2008) use voting on auditor ratification as a proxy for investor perceptions and discover a significant association between shareholders not

voting or voting against auditor ratification and long auditor tenure, suggesting that investors

view long auditor tenure negatively

Evidence Against Mandatory Audit Firm Rotation

Opponents of firm rotation suggest that artificially limiting auditor tenure would cause an overall decrease in audit quality as auditors with less exposure to the client do not have the necessary knowledge and expertise to ensure the appropriateness of the client’s financial statements (Moritz 2012) Elitzur and Falk (1996) attempt to model periodic rotation and find that a finite engagement period negatively affects planned audit quality until the last audit period Comunale and Sexton (2005) model the effects of firm rotation on the market shares of public accounting firms and reveal the detrimental impact rotation has on auditor independence as well

as quality Kornish and Levine (2004) examine mandatory firm rotation from the audit committee perspective and argue that such a policy prevents the audit committee from using threats of dismissal to punish the auditor More recently, Lu and Sivaramakrishnan (2009) provide a theoretical model that reveals the investment inefficiency created by a mandatory firm rotation regime

From 1989 to 1995, mandatory rotation existed in Spain In an archival study, Barbadillo et al (2009) use this context to test the effects of the rotation requirement on auditor independence By examining auditors’ likelihood to issue going-concern opinions to financially distressed firms during and after the mandatory rotation period, Ruiz-Barbadillo et al (2009) find that the required rotation did not affect auditors’ incentives Specifically, the authors discover that, regardless of the regulation, auditors are not incentivized by their desire to retain clients, but are incentivized by the desire to maintain their reputation (Ruiz-Barbadillo et al 2009) SDA Bocconi (2002) studies the effects of mandatory rotation on auditor independence in

Ruiz-Italy and finds the greatest number of qualified opinions in the third year of the engagement period, which the authors believe is due to the fact that auditors require three years to gain an in-depth knowledge of the client The SDA Bocconi study also reports that clients would retain their auditor for a longer period of time if the regulation did not require them to switch auditors

by the end of the ninth year (SDA Bocconi 2002)

In addition to Nagy (2005), Blouin et al (2007) study forced auditor changes around Arthur Andersen’s demise, but unlike Nagy they do not find an improvement in financial reporting quality Blouin et al (2007) partition former Andersen clients where the prior audit team follows the client to the new audit firm, and where the former Andersen client is served by

a different audit team (i.e., the proxy for the situation under mandatory firm rotation) Blouin et

al (2007) do not find a significant improvement in audit quality when a different audit team is used, and conclude that their finding is inconsistent with mandatory firm rotation improving financial reporting

A number of studies on auditor tenure find that longer auditor tenure is not problematic,

in substance or in appearance Geiger and Raghunandan (2002) examine firms in the years preceding bankruptcy and find a significant increase in audit reporting failures for firms in the early years of their audit tenure compared to longer auditor-client relationships Johnson et al (2002) indicate that short tenure (defined as three years or less) is associated with higher levels

of unexpected accruals, and they do not find a difference in unexpected accruals between clients with medium auditor tenure as compared with clients with long auditor tenure (defined as nine years or more) Carcello and Nagy (2004) find that fraudulent financial reporting is more prevalent when the auditor-client relationship is short and no more prevalent when the auditor tenure is long as compared to medium Myers et al (2003) find that higher earnings quality, as

measured by absolute abnormal and current accruals, is associated with longer auditor tenure Ghosh and Moon (2005) reveal that firms are less likely to engage in earnings management if they have a long-term relationship with their auditor

Mansi et al (2004) find that as auditor tenure increases, investors require lower rates of return on corporate bonds, which implies that investors value the development of an auditor-client relationship Boone et al (2008) examine whether or not investors price auditor tenure and note that a nonlinear relation exists between equity risk premiums and firm tenure The authors find that equity risk premiums decrease with increasing auditor tenure, until the thirteenth year after which the relation becomes positive (Boone et al 2008)

Overall, the literature on auditor tenure is frequently cited in the mandatory firm rotation debate, but it remains difficult to disentangle the impact of tenure on audit quality and independence Lim and Tan (2010) argue that the conflicting conclusions may be attributable to the failure to consider the effects of auditor expertise and fee dependence The authors find that with long auditor tenure, audit quality increases when the auditor is an industry specialist and the quality enhancement is even greater when the auditor has a lower fee dependence on its client (Lim and Tan 2010)

Hypotheses

We first examine investors’ overall perception of mandatory audit firm rotation by analyzing the market reaction to the six events outlined in Table 1 According to Schwert (1981),

a new regulation that could affect future cash flows will result in a change in asset prices as soon

as the market anticipates the regulatory change If implemented, mandatory firm rotation could affect a firm’s future cash flows given the likely increase in costs borne by the firm to deal with new auditors on a more frequent basis and the potential increase in audit fees as the new auditors

spend more time familiarizing themselves with the firm The PCAOB received many comment letters from public companies in response to the Concept Release that discussed significant additional costs that will not necessarily manifest in the form of audit fees General Motors, for example, explained that rotation would create significant disruptions to its business as the new auditor learns the business and control environment The comment letter also cited the “heavy burden” that would be placed on the company’s “personnel throughout the business and most directly on the accounting function, including at the executive level”, which will negatively affect the company’s ability to further improve its business (General Motors 2011) In its comment letter, Xerox noted similar issues and also referenced the substantial amount of time that would need to be devoted to the rotational selection process in the form of assessing competing auditor bids and holding several stages of interviews (Xerox 2012)

On the other hand, mandatory audit firm rotation may provide benefits to firms and investors by potentially improving audit quality Comment letters in favor of rotation cited that audit quality would increase due to the fresh perspective provided by new auditors and the improvements in auditor independence, objectivity, and professional skepticism If effective in improving audit quality, mandatory rotation would serve to reduce information risk As a result

of reduced information risk, investors should apply a lower discount rate in evaluating the present value of the cash flow stream associated with an equity investment, which serves to increase the stock price Prior research supports this supposition between the quality of accounting information and a firm’s cost of capital (Lambert et al 2007)

Examining the market reaction to events that affect the likelihood of implementing a mandatory audit firm rotation policy provides an opportunity to assess the expected benefits and costs of the policy (Zhang 2007; Li et al 2008; Armstrong et al 2010; Joos and Leung 2013;

DeFond and Zhang 2013) If the market anticipates that rotation will benefit the firm in the future, then the market reaction should be positive (negative) to events that increase (decrease) the likelihood of implementation If investors, however, are concerned that the potential benefits

of rotation will be outweighed by its costs, then the market reaction will likely be negative (positive) to events that increase (decrease) the likelihood of implementation (Armstrong et al 2010) As either a negative or positive reaction is plausible, we state the following null hypothesis:

H1: There will not be a significant market reaction, as measured by cumulative abnormal

returns, to the events that affect the likelihood of implementing a mandatory audit firm rotation policy

In addition to the descriptive analysis provided by the overall market reaction, we examine cross-sectional differences in market reactions based upon important firm and auditor characteristics The PCAOB’s Concept Release on audit firm rotation contemplated that all U.S public companies would be subject to mandatory firm rotation if implemented, but it is unlikely that they would all be affected by this policy in the same way Therefore, we analyze whether the market reaction to events related to mandatory firm rotation differs based on specific company attributes

As one of the main arguments cited in opposition to rotation revolves around the loss of auditor knowledge and experience, we examine differences in investor reactions based on whether or not the firm’s current auditor is an industry expert Given that industry expert auditors provide higher audit quality (Craswell et al 1995; Francis et al 2005; Reichelt and Wang 2010), switching away from an industry expert should increase information risk Therefore, we expect a more negative market reaction for firms with an expert auditor to events that increase the likelihood of implementing mandatory audit firm rotation We state our hypothesis as follows:

H2a: Firms with an industry expert as an auditor will experience lower cumulative abnormal

returns on the event dates that increase the likelihood of implementing a mandatory audit firm rotation policy.

Next, we analyze variations in market reactions based upon auditor tenure If investors believe that auditor independence is compromised as a result of longer auditor tenure (DeAngelo 1981; Gietzman and Sen 2002), then firms with longer auditor tenure should experience a more positive market reaction to announcements that increase the likelihood of rotation because this policy would force the firm to switch auditors and perhaps enhance independence If, however, investors value longer auditor tenure because they believe that auditors are able to provide a more effective audit as tenure increases (Myers et al 2003; Mansi et al 2004; Boone et al 2008), then the market reaction for firms with longer auditor tenure should be more negative to these events Given the conflicting literature on the impact of auditor tenure, we state the following hypothesis in null form:

H2b: There will not be a significant difference in the cumulative abnormal returns of firms based

on the length of auditor tenure on the event dates that increase the likelihood of implementing a mandatory audit firm rotation policy.

Another important distinction is whether or not a Big 4 accounting firm audits the company If a firm is currently audited by a Big 4 firm, it likely requires the resources that a Big

4 firm is able to provide Thus, if required to rotate, the firm would need to choose one of the other Big 4 auditors Rotating between the Big 4 firms severely limits a company’s auditor choices and becomes nearly impossible if the company is using other Big 4 firms for various services, including tax and internal audit Given the lack of options and the additional challenges rotation poses for firms audited by a Big 4 firm, we predict the following:

H2c: Firms audited by a Big 4 accounting firm will experience lower cumulative abnormal

returns on the event dates that increase the likelihood of implementing a mandatory audit firm rotation policy

Finally, we examine differences based on audit quality to isolate a group of firms where the benefits of rotation might be most pronounced – firms currently receiving a lower quality audit Investors in firms with lower quality audits likely view rotation as a means to improve their audit quality Firms that are already receiving high quality audits, however, likely view rotation in a negative light given that they risk losing their effective and desirable auditor As such, we predict the following:

H2d: Firms currently receiving a higher quality audit will experience lower cumulative

abnormal returns on the event dates that increase the likelihood of implementing a mandatory audit firm rotation policy

III RESEARCH METHOD Determination of Event Dates

As described in Section II, we examine six event dates that affect the likelihood that the PCAOB will implement a mandatory audit firm rotation policy in the United States To identify these events, we first searched the PCAOB’s website for speeches, news releases, meetings, and other announcements pertaining to mandatory firm rotation We also used Factiva to search for other news related to the mandatory rotation debate in the United States.7 Of these six events, we view the first two events as increasing the likelihood of implementing mandatory audit firm rotation and the remaining four events as decreasing the likelihood of implementing mandatory rotation Table 1 lists the six events and presents their likelihood classification (increasing or decreasing)

<Insert Table 1 Here>

7

While there have been several other announcements and meetings that relate to mandatory audit firm rotation, we only include events that contain new information related to the rotation discussion For example, the PCAOB held public meetings on auditor independence and rotation in Washington, D.C., San Francisco, and Houston These roundtable discussions did not present significantly different information than had already been expressed in other meetings and speeches We therefore would not expect the market to adjust their expectations of the likelihood of

Test of Overall Market Reaction

To test the overall market reaction to the prospect of mandatory audit firm rotation, we examine three-day cumulative market-adjusted returns centered on each event date, following Armstrong et al (2010) and Joos and Leung (2013) As the PCAOB proposed that all U.S public companies would be subject to mandatory firm rotation if implemented, it is not appropriate to use a U.S index as our market index.8 We therefore use the value-weighted MSCI world index excluding the U.S (we refer to this index as the “world index”) to estimate the impact of other economic news on U.S returns during the event periods The difference between our sample firms’ cumulative returns and the cumulative returns of the world index provides the cumulative market-adjusted returns (we refer to these returns as the “World CARs”).9 Prior finance literature, such as Eun and Shim (1989) and Hamao et al (1990), finds that U.S firms and foreign firms are exposed to “substantial common economic news”10

(Zhang 2007) The majority

of foreign firms, however, are not affected by changes in U.S regulation, including the potential implementation of mandatory audit firm rotation.Therefore, the foreign market index reflects the impact of global economic news affecting both U.S and foreign markets but does not account for the impact of news related to the possible U.S implementation of mandatory firm rotation.11

While the world index should alleviate concerns related to worldwide confounding events, it might be argued that European firms are affected by the U.S rotation events because European regulators are also debating whether to require mandatory audit firm rotation It is

possible that European regulators might be more (or less) likely to require firm rotation if the U.S becomes more (or less) likely to adopt rotation To the extent that European companies react to the U.S rotation events, the use of the foreign market index, which includes these European firms, will eliminate part of the market reaction we aim to capture and therefore biases

us against finding significant results

In addition to the specifications described above, we perform the analysis using three-day non-event market-adjusted returns Following Armstrong et al (2010) and Joos and Leung (2013), we compute the cumulative market-adjusted returns for three consecutive non-event trading days beginning with the first trading day in 2011 We repeat this process for all non-event trading days in 2011 and 2012 without overlapping the three-day windows We use the non-event market-adjusted returns to determine the significance of the overall market reaction This procedure tests whether or not we are documenting returns for our events of interest that are significantly different from our sample firms’ returns on other days in 2011 and 2012

Tests of Differences in Sample Partitions

After estimating the cumulative abnormal returns, we partition the sample in four different fashions and test the differences in stock market reaction for firms: (1) with an industry expert as the auditor and firms without an industry expert as the auditor, (2) with long auditor tenure and short auditor tenure, (3) audited by a Big 4 accounting firm and firms audited by a non-Big 4 accounting firm, and (4) currently receiving a higher quality audit compared to firms receiving a lower quality audit Following Lim and Tan (2010), we define auditors with a large industry market share as an industry expert Industries are based on two-digit SIC code and the threshold for a “large” industry market share is 30 percent of total industry audit fees (Neal and Riley 2004; Lim and Tan 2010) We measure auditor tenure as the cumulative number of years

the audit firm has been engaged by the company (Lim and Tan 2010), and define long tenure as tenure greater than 10 years in order to isolate the group of firms specifically mentioned in the PCAOB Concept Release Big 4 is an indicator variable equal to one if the firm is currently audited by a Big 4 public accounting firm We use abnormal accruals to proxy for audit quality and specifically focus on the piecewise modified Jones model (Dechow et al 1995; Ball and Shivakumar 2006) The median value of absolute abnormal accruals is used to define high audit quality versus low audit quality.12

Cross-Sectional Analysis

In order to further test hypotheses H2a-H2d, we perform cross-sectional analyses and

control for other factors that potentially influence market returns We initially include each test variable (industry expert, Big 4, tenure, and abnormal accruals) individually before including all test variables in the same regression model We follow this approach as three of our test variables – industry expert, Big 4, and abnormal accruals – could each be viewed as proxies for audit quality In addition, we control for (1) firm size, measured using the natural log of total assets, (2) firm performance, measured using return on assets, (3) firm growth opportunities, measured using the firm’s market-to-book ratio and sales growth, (4) firm ownership, measured using the percent of institutional ownership, and (5) industry, measured via Fama-French 48 industry controls (Zhang 2007; Li et al 2008) All independent variables are determined as of the year prior to the event Our regression model is:

WorldCAR it = β 0 + β 1 (Expert it or Tenure it or Big4 it or Accruals it) + β2 Size it + β 3 ROA it + (1)

β 4 MTB it + β 5 SalesGrowth it + β 6 InstOwn it + β 7 Industry it + ε it where i denotes an individual firm, t denotes an event, and: